It looks very much as if we are in for a rough few weeks at least. So I wondered if now might be a good time to consider what “rough” means in trading terms?
Now imagine the same line but going up /. That is your asset gaining in value.
Now normally, you would think of the profit as being how much the line has risen. This is where you need to adjust your understanding to appreciate the critical importance of volatility in shaping modern trading. The height of the line, where it reaches is indeed how much the asset is now worth. Now, however, you have to think of the profit as being measured by the length of the line. The diagonal is longer than the flat line. For as long as you own that asset you track that line and the profit is yours.
That straight diagonal line is the old fashioned buy and hold trading strategy. The one used by little old ladies and fat gents. They buy a ‘good’ company with ‘prospects’ or better yet a blue chip company and wait for their broker to call or their butler to bring the dividend check. You get to spend the dividend and feel warm inside looking at how much the value has risen.
By buying and holding the asset they got all the profit of that rising line. The steeper it goes up, the longer the line, the more profit you made. It’s the kind of investing you do, if what you do is look for the fundamentals of a company – its patents, fixed assets, cash etc. It’s an easy and accurate graphic device. But it limits you.
You see, although you got all the profit described by that line, you could have had so much more. What more could you get? Well actually a lot more. Potentially a vast amount more. All you need for this magic is volatility.
Volatility is when instead of a smooth line, it jigs up and down the way we have all seen the stock market index do. That jigging up and down IS volatility. The old fashioned way of seeing it, however is to dismiss it, as just the noise in the underlying signal. The underlying signal is the smooth average line you can draw through the zigs and zags to give you an an over all or average picture. Which is the smooth line the old lady and gent are used to. “Spare me the details,man! is it worth more or less?”
This person is living in yesterday, however, and will shortly be ruined by a world of volatility trading he does not understand.
All you have to do is notice that the zigzag line is LONGER than the straight, smoothed out average line. This is the key to modern markets and modern trading, and why, what is happening in the markets, is happening.
If you trade the smooth line ignoring the zigzag your line is short. If you can trade the zig zags your line is longer. But the zig zags have less to do with the intrinsic long term qualities of the company and more to do with events and circumstances outside of the company. The sea on which the company floats. Those external events create the waves which bob your company about. Lending rates, oil costs, politicians raising the minimum wage, or a a crisis in bank lending that cuts off your ability to borrow money for investing in new machinery, for example.
Now imagine you knew much less about the company itself, but a lot about all these external circumstances. You might be more attuned to and therefore better able to anticipate and track, some of these events. If you could do this, you could change how you trade totally. Instead of buying and holding, and ignoring all the zig zags and getting the increase of the straight line only, you buy and sell like crazy. You sell just before it zags down and buy it back just before it zigs up. If you do it with more than 50% accuracy, then the line you are following, your profit, is LONGER than the straight line. A lot longer.
Now you are not really investing any more. You are beginning to trade or speculate.
Let’s ramp it up.
Now you don’t worry about many of the details of the companies you trade at all. You have realised that all the companies, good and bad are bobbed about by the same forces – they are on the same sea. You put your effort into knowing how the sea is going to be. Now rather than do research into the companies, you research the sea and its weather. You try to get to know who and what might make waves. If you know what and who makes them, lets say who is setting interest rates and when – and you can get to know it before other people do, you will know when the zig and zags are going to happen before they do. You will trade those zigzags at much closer to 100% accuracy and will be hailed as a genius. (This is insider trading or ‘being well connected’)
Now let’s go even further. You now no longer buy anything tangible at all. Instead you take bets with someone on which way the line of value will go, zig or zag. You don’t buy the asset you are just betting on the line. Now you are trading in derivatives. Congrats.
Now lets notice one more thing. If you get out a magnifying glass you will see that every zigzag has smaller zigzags embedded in it. Like a fractal, the line has more detail as you magnify it. By magnifying the line you are in effect looking at it at smaller time scales. As with fractals what you suddenly realise (and this is what they did realise starting in the 80’s) is that as you magnify the line IT GROWS LONGER. There is in fact much more of the line in these tiny little wiggles than the human eye can see or track.
But imagine IF you were superman and could move fast enough to track those changes – buy and sell each and every one. Of course, the changes are tiny fractions of value, BUT there are THOUSANDS of them. Cascades of them packed into every second of every day. Trade them all, stay on the right side of the line and maybe trade millions of shares at a time. All you need to do, apart from being inhumanly fast, is to also be rich enough to buy a million shares. If you can do this, then a hundredth of a dollar change in value on a million shares has made you a thousand dollars in a micro second.
All it needed was the invention of the computer and a few whizz-kid programmers to build machine trading computers, and away Goldman Sachs goes. Congratulations again. Now you are an HFT ( High Frequency Trader).
And this just about wraps this excursion up. Except to bring this discussion of volatility and trading in it, up to today and what is happening in the world.
HFCs are brilliant at tracking the tiny flickerings of the line. Extracting almost the entire length of the line as profit OR LOSS. If you are on the wrong side of the line your profit turns to loss on the same speed and scale. The danger is that the machines cannot see larger zigzags. SO when a really large zig hits them, they glitch. They react according to a routine in their programme which is there to stop the machine from getting caught out when the market drops to far, too fast. The machines either SELL and track the sell down to stay ahead of it, or they simply shut down and a vast chunk of the market’s liquidity disappears. Either one is not good for everyone else. And what makes it so dangerous is that it happens at a speed no human can even see, let alone stop. That is a large part of what happened yesterday. It has happened before and will happen again.
What sparks it is – volatility. The thing they are trading, that the whole modern market is based on – can also kill the whole thing.
Volatility is fine when it is relatively tame. Like a wind that fills the sails. But if the storm is too violent you can sink.
The modern markets are trading volatility. They need it. They make it. They get others to make it for them – and tell them they’re going to do it and when. They try to get inside knowledge of who will make what waves. Those who get to know ‘front run’ events. They cheat.
I have been talking in terms of ‘assets’ rather than just shares for a reason. The reason is that debt is traded exactly the same way.
No one buys and holds debt. They trade it. Its value goes up and down. It is volatile. If the markets can create debt volatility, by, let’s say, speculating on default using CDS bets – then they can track and trade that misery, for profit. That is what has been happening and what is going to happen more and more.
Volatility is what makes the world go up and down! Sadly their ‘up’ and our ‘down’.